Ditch The Knee-Jerk Derivatives Cynicism, Citi's Financial Crisis Insurance Is A Great Idea

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As highlighted by Felix Salmon and our colleague Joe Weisenthal, Citi is close to producing a new kind of derivative that would allow companies to hedge against financial crisis — essentially receiving a massive payout from their derivatives counterparty in the event of a crisis.Particularly they’d allow companies to hedge against sharply rising funding costs, as happened during the credit crunch.

Felix Salmon @ Reuters:  I’d forgive you if your eyes started rolling after just the first four words: the phrase “credit specialists at Citi” is not exactly the kind of thing which instills enormous confidence in analysts and investors these days.

It’s crucial, in financial markets, that investors walk into risky asset classes with their eyes open, rather than kidding themselves that they can simply hedge those risks away by buying a fancy financial product from Citigroup. But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things.

It’s easy to sink into knee-jerk cynicism towards any new financial product these days, but it isn’t very productive.

The concept of creating insurance against risk is sound. Huge risks exist without insurance, insurance just attempts to match people with opposite risk exposures, thus hedging away some of the world’s risk.

In fact companies already hedge against moderate changes in funding costs every day using interest rate swaps, which are one of the most common and well established derivatives out there. Swaps can frequently be hedged between different companies who have opposite risk exposures, thus eliminating risk for both. Vast amounts of derivatives transactions happen daily allowing companies to hedge themselves from the vagaries of markets and focus on their core operations.

Risk.net: However, there is concern from academic circles that the counterparty risks involved in such a product could create moral hazard. Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail.

Thus there are concerns for these new Citi derivatives similar to those for credit default swaps that insure against bond defaults.

Yet we’d point out that credit default swaps are inherently risk-reducing products. They just got a bad wrap due to some stupid exposure accumulated pre-crisis by AIG. Even if credit default swaps didn’t exist, bond defaults would still happen during a crisis, causing hideous losses to certain investors. CDSs are badly needed, and this will be shown over time  as demand for the insurance protection they provide explodes over the next decade.

To address the concern above, given that we unfortunately now live in the age of too big to fail, perhaps the sale of ‘financial crisis swaps’ would need to be regulated in order to make sure the government doesn’t have to step in and cover their losses one day, just as is happening right now with CDSs.

But let’s not fear innovation just for the sake of being cynical, especially when it comes to hedging risk. It’s too easy to forget all the financial advances we benefit from.

RIsk.net: “The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it,”

 The old ‘uh oh, financial innovation, here we ago again line’ is pretty tired and backwards looking.

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